Front Matter Page
Research Department
Authorized for distribution by Michael Mussa
Contents
Summary
I. Introduction
II. The Model
1. Preferences
2. Firms and the Structure of Goods Markets
3. Foreign Demand
4. Government
5. Household Budget Constraint
6. Price and Wage Determination
a. Predetermined Prices and Wages
b. Calvo-Type Price and Wage Determination
7. The Household’s Intertemporal Decisions
8. Equilibrium and Solution Method
9. Parameterization
a. Preferences and Foreign Demand
b. Price and Wage Adjustment
c. Exogenous Variables
III. Stylized Facts About Economic Fluctuations (Post-Bretton Woods Era)
IV. Simulation Results
1. Predetermined Prices and Wages
a. Money Supply Shocks
b. Other Types of Shocks
c. Combined Effect of Four Types of Shocks
2. Calvo-Type Price and Wage Adjustment
V. Conclusion
Appendix
Tables
1. Economic Fluctuations in Post-Bretton Woods Era
2. Model Predictions with Predetermined Prices and Wages
3. Model Predictions with Calvo-Type Nominal Rigidities
Figures
1. Prices and Wages Set 4 Periods in Advance--Response to Money Supply Shock
2. Prices and Wages Set 4 Periods in Advance--Response to Productivity Shock
3. Prices and Wages Set 4 Periods in Advance--Response to Foreign Price Level Shock
4. Prices and Wages Set 4 Periods in Advance--Response to Foreign Interest Rate Shock
5. Calvo-Type Price and Wage Adjustment--Response to Money Supply Shock
References
Summary
During the last 15 years, much effort was devoted to developing open-economy business cycle models with explicit microfoundations. With rare exceptions (discussed below), that literature considered models without money or in which money is neutral (or almost neutral), with prices and wages assumed fully flexible. A striking limitation of these models is that the predicted variability of nominal and real exchange rates is much too small compared with actual data for periods with flexible exchange rates.
Recent research, however, has developed dynamic–optimizing open-economy models that do not assume fully flexible prices. This paper builds on work by Obstfeld and Rogoff (1995) and by Beaudry and Devereux (1995), who study models in which firms set their prices one period in advance. Those models, too, seem unable to generate sufficient exchange rate volatility.
In the model in this paper, nominal prices and wages are set two or four periods in advance (one period represents one quarter in calendar time). In addition, a mechanism inspired by Calvo (1983) is considered that assumes that nominal prices and wages are changed after random time intervals. A semi-small open economy model with four types of exogenous shocks is assumed: shocks to the domestic money supply, to domestic labor productivity, to the world price level, and to the world interest rate.
The predicted variability of nominal and real exchange rates is roughly consistent with that of G-7 effective exchange rates during the post-Bretton Woods era. The model exhibits exchange rate overshooting in response to money supply shocks. A positive shock to the domestic money supply is predicted to lower the domestic nominal interest rate, to raise domestic output, and to trigger a nominal and real depreciation of the country’s currency. In the model, money supply changes are the dominant source of exchange rate fluctuations.